The Price of Civilization

by Jeffrey D. Sachs

  This is all pretty thin gruel. The supposition that there is massive waste to be cut in the civilian budget is simply a myth. To recapitulate: ending all earmarks and foreign aid and achieving all of the specific cuts on civilian programs proposed by the deficit commission, even if such choices were meritorious, would amount to less than 1 percent of GDP.

  True health care reform, the kind that not only expands coverage but actually reduces America’s bloated costs, could probably save as much as 1 percent of GDP per year in net budgetary outlays (lower spending and higher taxes) in reforms carried out over several years. This budget saving would reflect a combination of lower direct outlays for government-provided health care (such as Medicare) and a cutback on the deductibility of private health insurance, especially of high-cost plans purchased by high-income individuals.

  This leaves one more part of the budget: the military. Here the prospects for budget savings are even brighter. The Iraq and Afghanistan occupations currently bloat the military budget by around 1 percent of GDP. Another 1.5 percent of GDP could certainly be cut back on procurement of unneeded nuclear weapons and other weapons, and a scaling back of international military bases. The military budget could be trimmed to around 2.5 percent of GDP by 2015, which is 1.5 percent of GDP less than in the baseline that I just outlined.

  In total, cutting military outlays to 2.5 percent of GDP would reduce the baseline deficit to 4.5 percent of GDP in 2015. Another 0.5 percent of GDP could be saved in areas identified by the deficit commission and another 1 percent on true health care reform. In total, we might trim around 3 percent of GDP from the baseline deficit in these categories, leaving a 2015 deficit of some 3 percent of GDP.

  Yet that is not the end of the story. We have not yet factored in the need to augment certain spending programs even as we cut others. According to the discussion in the preceding chapter, we need to increase outlays on certain public goods. The list from the preceding chapter is as follows, together with my rough estimate of the additional spending that is needed as a percentage of GDP:

  Job training, job matching, and other active labor market policies, 0.5 percent

  Primary and secondary schools, 0.3 percent

  Higher education, 0.4 percent

  Child care and early childhood development, 0.5 percent

  Modernization of infrastructure, 1 percent

  Research and development, 0.3 percent

  Diplomacy and foreign assistance, 0.5 percent

  This suggests that the current spending needs to be augmented by around 3.5 percent of GDP in order to meet the vital challenges of jobs, schooling, early childhood development, infrastructure, and international affairs. Let’s be conservative and round down to 3 percent of GDP in the added outlays needed to address the country’s structural challenges in education, infrastructure, science, and other areas.

  The upshot is the following: We start with a baseline structural budget deficit of 6 percent of GDP. We can identify justified savings of perhaps 3 percent of GDP from that in spending, mainly by cuts in the military and reductions in health care costs. But we must add back another 3 percent of GDP in spending to increase the supply of public goods. The chronic financing gap for mid-decade (2015) is therefore on the order of 6 percent of GDP, taking into account the plausible cuts in existing programs plus the plausible need to expand other programs.

  In this scenario, total federal spending would settle at around 24 percent of GDP in 2015, compared with revenues of around 18 percent. No doubt those are rough numbers in need of refinement. Still, they point us to the essential conclusion: that the United States will need substantially more revenues to close the budget deficit, especially recognizing the need to increase federal spending in certain critical areas.

  I have been relatively conservative in the added spending that is needed. These projections do not make room for any significant transfer of income to relieve poverty, offer new housing assistance, or cover a jump in interest rates on the public debt. They assume that defense outlays as a share of GDP can be reduced by half of the current level, from 5 percent to 2.5 percent, an approach that will certainly be resisted by the Pentagon and many key interest groups. If these assumptions are too optimistic, the budget deficit in 2015 is likely to be much larger than estimated, with the need for even more stringent measures to raise revenues or cut spending.

  Let me add a final note on the work of the Obama deficit commission. The deficit commission assumed that total spending and revenues could settle at 21 percent of GDP. It did so because it utterly neglected the need for existing, much less new, civilian spending in key areas such as infrastructure, education, training, and R&D. It is relatively easy to balance the budget if one presumes that new kinds of public spending are not needed. Yet that is no way to pay for civilization.

  Budget Lessons from Abroad

  All of this discussion prompts a crucial question: how do Canada, Denmark, Norway, Sweden, and other countries manage to educate their young, fight poverty, modernize their infrastructure, enjoy a life expectancy well above America’s, and still maintain a budget that is more in balance than America’s? After all, in 2010, the United States had the second-largest budget deficit as a share of GDP among the high-income countries, ahead of only Ireland (see Figure 11.3). The social democratic economies of northern Europe, where government plays a much larger role in the economy, had deficits under 3 percent of GDP in Denmark, Finland, and Sweden, with a surplus of 10 percent of GDP in Norway, achieved mainly by saving a considerable fraction of its oil and gas revenues for the benefit of later generations.

  Figure 11.3: Budget Deficit in OECD Nations as Percentage of GDP, 2010

  Source: Data from OECD.

  The answer, of course, is that the other countries tax their citizens more heavily in order to supply more public goods, including, in the case of Scandinavia, universal access to health care, higher education, and child care and support for families with young children. The comparison in tax collections is shown in Figure 11.4. The United States has the second lowest tax revenues as a share of GDP among all of the countries shown, just slightly larger than Australia. We see that the countries in deepest budget crisis in 2010 were not those with among the lowest nor the highest government spending, but those with the lowest tax revenues: Greece, Ireland, Portugal, Spain, the United Kingdom, and the United States. All these countries are running enormous budget deficits. They seek to provide public services and income transfers but are not willing to pay for them through public revenues.

  Figure 11.4: Tax Revenues as a Percentage of GDP for OECD Nations, 2009

  Source: Data from OECD Statistics Database.

  To understand America’s budget predicament, it is useful to examine the changes in tax revenues as a share of GDP that have taken place in the United States and other high-income countries since the early 1960s. Half a century ago, both the United States and European countries had a similar level of total taxes relative to GDP, roughly 30 percent (counting national, state, and local taxes). In the United States, that level has remained roughly unchanged for five decades. In Europe, taxes as a share of GDP have risen by around 10 percentage points on average. These changes are shown in Figure 11.5, which measures the rise in revenues relative to GDP, comparing 1965 and 2009. In the United States, there has been essentially no change in the tax-to-GDP ratio since 1965. In Europe, the tax-to-GDP ratio has risen in all countries, by 5 to 20 percentage points of GDP. Europe has used that rise in tax revenues to pay for a more extensive range of public services, as shown in Figure 11.6: education, family allowances, universal health care, and modernized infrastructure. It has also used the higher revenues in general to keep the budget deficit under control.

  Figure 11.5: Change in Tax-to-GDP Ratio Between 1965 and 2009 for OECD

  Source: Data from OECD Statistics Database.

  The divergence between the United States and Europe reflects a divergence both of fiscal means and of fiscal ends. Though Europe general
ly has higher tax rates on all kinds of income, the biggest difference with the United States is that European countries all have a value-added tax (VAT) as a cornerstone of the budget. In Europe, the VAT routinely collects around 10 percent of GDP. In the United States, by contrast, the federal budget collects less than 1 percent of GDP in excise taxes akin to the VAT. This is the main difference in the fiscal means.

  Figure 11.6: Gross Public Social Spending as a Percentage of GDP, 2010

  Source: Data from OECD Social Database.

  The main difference in the fiscal ends is a divergence in the vision of government in the United States and Europe. In the United States, the anti-government politics that became the dominant political thrust of the last thirty years blocked an increase in total tax collections as a share of GDP. The United States therefore cut back on public investments in education, science, energy, and infrastructure, and squeezed outlays for the poor, just when they were most urgently needed.

  Anti-tax ideologues in the United States claim that Europe pays a heavy price because of its higher taxes. This is hard to swallow, however, given that northern Europe is ahead of the United States on most indicators of material well-being: educational performance, subjective well-being, poverty rates, life expectancy, and so forth. Yes, it’s true that GDP per person is still higher in the United States than in most of Europe (though not higher than in Norway, for example), but that really doesn’t prove much about taxes or even about social well-being. U.S. GDP per person may be higher, but the average living standard of the median citizen is not: much of America’s higher GDP reflects higher health care costs, longer work hours and less leisure time, longer commutes, more military spending, and a high proportion of income at the very top of the income curve.

  More important, the higher GDP per person predates any differences in tax systems, stretching back to the late nineteenth century. In 1913, for example, America was 52 percent richer than Western Europe, and in 1998, it was also 52 percent richer than Europe.19 America’s long-standing advantage in GDP per person has been in its geography rather than its economic system. America has vastly more land and natural resources per person than Europe does. This has been the source of its enduring advantage (just as Norway’s high oil and gas earnings account for its higher GDP per person than in the United States). Americans have bigger houses, bigger farms, and bigger cars, not to mention more natural capital per person in the form of oil, gas, and coal. These have been the sources of America’s higher income per person stretching back to the nineteenth century.

  The real point for us is that despite America’s vast natural resource advantages, it has actually ended up with a lower average quality of life in many ways than in northern Europe. Yes, America’s GDP per capita is higher, but it is not bringing widespread benefits for the society. To ensure that the benefits reach more of society, the United States will have to invest more in public outlays for education, infrastructure, and the other priorities that I’ve identified.

  Budget Choices in a Federal System

  Americans will surely need to pay higher taxes to balance the budget and “pay for civilization.” Yet another thought arises: why not allow tax and spend decisions to be made at the state and local level? Areas that would like to provide more public goods could do so, and areas that are averse to public goods could organize their states and cities as they see fit. To some extent, of course, this already happens. The federal government accounts for about 65 percent of total revenues, while state and local governments account for 35 percent.20 There is a huge variation in taxes per citizen across the states. My own state of New York has an income tax that rises to a top rate of 9 percent, and New York City adds another 2.9 percent. The state sales tax rate is 4 percent, plus another 4.875 percent in the city. New Hampshire, by contrast, has neither an income tax nor a sales tax.21

  Economists use the concept of “fiscal federalism” to denote the situation in the United States, Canada, China, India, and elsewhere, in which governments at the national, state (or provincial), and local level have their own tax collections and separate provision of public goods. The system may include collection of revenue at one level of government and its transfer to another, such as when the federal government collects revenues and then returns them to the states as block grants to administer various programs. The question then arises as to the appropriate levels for collecting revenues and providing public goods and services. Why not, for example, simply leave the decisions to the most local level and thereby allow maximum freedom of choice? There are three reasons.

  First, certain public goods are best provided at a higher level of government. National defense, clearly, should depend on the federal government, not the fifty states. Some are clearly the responsibility of governments at all levels, such as planning and implementing the national highway system or a national power grid. In these cases, indeed, the situation is even more complex because the goods and services involve the private sector alongside multiple levels of government.

  Second, there is a collective action problem that makes tax collection more convenient at the higher level of government, that is, at the federal level rather than the state and local level. The fifty states are in competition with one another for businesses and wealthy citizens. By keeping its tax rates just a bit lower than the others’, each state can attract business and revenues. Yet the result is a race to the bottom, as described for the global economy in tax competition between nations. Each of the fifty states shaves the tax rate to entice business to come over the state border, until all of the states together are starved for cash. The race to the bottom among the states can be obviated in part by a unified federal tax collection that is then returned to the states so that they can implement programs that are tailored to each state’s needs.

  Third, the differential provision of public goods in different jurisdictions leads to mobility of households as they sort themselves in response to the changing tax and spending conditions of the state and local governments. In part this is exactly what is desired. Economists have long studied a conceptual model in which sorting allows each household to choose just the spot where it would like to live: the place that delivers just the right combination of parks, good schools, public concerts, and other amenities, balanced by high or low tax collections as needed to supply that level of public goods. The result is a “Tiebout equilibrium,” named after the economist Charles Tiebout, who first proposed it.22

  In some cases this sorting can work well, but there are obvious reasons why it can create enormous trouble. If one jurisdiction decides to provide more generous help for the poor, it ends up being flooded by low-income residents in just the same way that businesses and wealthy individuals flee from high-tax jurisdictions. Once again, there is a race to the bottom when it comes to supporting the poor, which is a public function that should be shared across the society, not a small part of it. Similarly, the sorting will tend to lead to segregation by income, as rich households move to affluent jurisdictions in search of good schools and other public amenities. Land prices and property taxes increase, squeezing poorer families out of the more affluent communities. The society divides between rich communities and poor communities, with reduced spillovers and contacts between the various parts of society. This can leave the poor trapped in poverty, resulting in a massive loss of well-being not only for the poor but also for the rich, who end up absorbing the indirect costs of poverty (in terms of lower worker productivity, higher crime rates, larger transfer programs, more political instability, and so forth). The point is that when there are spillovers in human capital, the sorting of the population across local jurisdictions can be disadvantageous for the entire society, rich and poor alike. The solution is an adequate provision of public goods across the entire society by the federal government, as a backstop to local financing and local provision of services.

  The upshot of these considerations is that local governments are often the most effective providers of public goods such
as schooling, public health, and local infrastructure (roads, water and sewerage, and other systems), since these programs are best tailored to local needs. At the same time, the federal government should supplement local financing by collecting federal taxes and transferring them to state and local governments for local implementation. The famous subsidiarity principle should in general determine the level of government best suited for implementation. The subsidiarity principle holds that the public good should be provided by the lowest level of government that is competent to provide it, for example, schools at the local level, major roads at the state level, national highways and national defense at the federal level. Americans, quite rightly, strongly endorse subsidiarity. A robust 70 percent of Americans endorse the view that “the federal government should run only those things that cannot be run at the local level.”23

  Here’s the bottom line. Currently the United States collects around 18 percent of GDP in tax revenues at the federal level and another 12 percent of GDP at the state and local levels. Washington currently returns around 4 percent of GDP in tax revenues to the states to implement health, education, and infrastructure programs at the state and local levels.24 To close the budget deficit and implement needed new spending programs, the United States will have to raise overall tax revenues by several additional percentage points of GDP. I am suggesting that, to the maximum extent feasible, the new spending programs—for education, early childhood development, infrastructure, and so forth—should be implemented at the state and local levels using increased taxes collected by Washington but then returned to the individual states for program design and implementation.

  Time for the Rich to Pay Their Due